Effective Tax Rate, ETR, and Direct Capitalization Page 1 of 16
EFFECTIVE TAX RATE In Direct Capitalization
Example using
Direct Capitalization to estimate value and using
Effective Tax Rate in the Capitalization Rate instead of Real Estate Tax as a line item expense.
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Effective Tax Rate, ETR, and Direct Capitalization Page 2 of 16 for the following examples: INCOME V&C may be actual if Potential Gross Income ( PGI ) $70,000 available, but should look forward (buyer thinking) -V&C: Vacancy and Collection Allowance 5.0% 3,500 Effective Rental Income 66,500 Reimbursements from
+ Reimbursements (if lease requires CAM reimb. By tenants to owner) 1,800 tenants, if any, depending on terms of leases. +Other Income (stg, parking, vending) 5,800
=Effective Gross Income after other & Reimbsmts (EGI) 74,100 For assessing, taxes -Less Owner’s Operating Expenses (examples) unknown, so use zero; then add effective tax rate to Real Estate Tax* 3,000 the capitalization rate to Insurance 900 calculate value. Maintenance and Repairs 1,500 Paid by owner, but all or Common Area Maintenance (CAM)* 2,000* part reimbursed from Utilities 5,000 tenant. Sometimes not all reimbursed because of Promotion, Advertising 500 vacancy or all tenants not under the same lease Management 10% EGI 7,230 provisions. Legal and Accounting 1,200 Comment re valuation Other, Trash Collection, pest control, etc. 800 without reserves for replacement: include if Total Operating Expenses 22,130 buyers in the market do in Reserves for Replacements (short life items; examples) their forecasts of income when purchasing an income Roofing $ 50,000 /10yr $5,000 property. Often depends on type and size. Required by Painting 60,000/ 10 6,000 lenders.
HVAC 24,000/ 8 3,000 Plumbing 15,000 / 15 1,000 Net Operating Income is BEFORE debt service Carpeting 12,000 / 6 2,000 (principal and interest) on Appliances 16,000 / 8 2,000 loans. To value the property as fee simple Total Reserves 19,000 without mortgage or contract loan. =Total Operating Expenses & Reserves 41,130
Net Operating Income NOI, or I, or Io 32,970
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Application of Direct Capitalization: A ratio model is used using Rate as discussed above derived by the foregoing methods. Value = Income / Rate Income = Rate * Value Rate = Income / Value or Sales Price
First, derive the income to be used from subject and comparable rental – lease information. Second, derive the overall rate to be used from the market, sales producing income at the time of sale (must be similar building ratio, expense ratio, remaining economic life, risk, property type, age/condition, buyer/investor desirability, etc.) Third, apply in the V+I/R model.
1. Assume subject experience and market rentals indicate a PGI of 70,000, a 5% vacancy, and a Net Operating income of $32,970 as shown on the prior example of calculating NOI. From market information of similar properties with similar leases (i.e. similar terms, conditions, features, site ratios, expense ratio, remaining economic life, )
2. Derive an appropriate overall Rate from the market:
Derivation of Overall Rate (R or Ro) from market information.* Property Sales Price Sale Date Net Op. Income Ro [Overall Rate] 1 $250,000 3 mo ago $28,500 .1143 or 11.40% 2 $200,000 8 mo ago $21,000 .1050 or 10.50% 3 $325,000 4 mo ago $36,400 .1120 or 11.20% Analyst concludes appropriate rate is 0.110, or 11.0% 3. Calculate value indication amount by Direct Capitalization by applying the Rate to the estimated subject net operating income:
Value = Income/Rate: Net Operating Income $32,970 divided by Overall Rate 11.0% = 32,970 / .11 = $299,727 rounded to $300,000.
* NOTE 1: comparable properties should have the same land to building ratio, expense ratio and remaining economic life; if these items are significantly different in the comparables as compared to the subject, mismatch can result and the extracted rate undependable or misleading. * NOTE 2: Comparable and competitive listings may also be included to indicate upper limits of price and lower limits of rates to help bracket the conclusion for the subject.
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Direct Capitalization to value an income producing property Using the foregoing example, Estimating value for ‘ad valorem’ real estate taxes:
The real estate tax amount is not known (because we are estimating value which is necessary to calculate the real estate tax amount) but the effective tax rate can be found and is knowable. Assume an effective tax rate of .01510 (more about where the effective tax rate number may be found or calculated later in these pages) Real estate tax in the foregoing calculation of net operating income was $3,000, so the net operating income without including real estate tax in the expenses would be $37,400.
The comparable sales from which the overall rate derived are:
Derivation of Overall Rate (R or Ro) from market information.* Property Sales Price Sale Date Net Op. Incm w/o tax Ro [Overall Rate] 1 $250,000 3 mo ago $28,500 .1143 or 11.43% 2 $200,000 8 mo ago $21,000 .1050 or 10.50% 3 $325,000 4 mo ago $36,400 .1120 or 11.20%
Analyst concludes appropriate basic rate is 0.110 or 11.0%; PLUS the ETR of 0.01510 resulting in a loaded capitalization rate of .1271 . So the value for ad valorem taxation would be* V = I / R ; I = (32,970 + 3,000* = 35,970) and R = 0.1271; so 35,970/ .1271= $283,005 rounded to $283,000.
* Removing the above line-item real estate tax expense, thus raising the indicated Net Operating Income. Note: The value calculation is not the same as the foregoing $300,000 which included actual real estate tax as a line item expense because the actual tax of $3,000 is only 1% of the value estimate rather than the effective tax rate of 1.51%
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EFFECTIVE TAX RATE – where do you get it? The Department of Revenue, in its publication “Assessment Procedures Manual” Part Two, Chapter 1, Approaches to Value, discusses effective tax rate. (see that publication (pages 2.1.33-38): In Arizona, there are two ways of developing the effective tax rate: 1. the direct method 2. the market comparison method.
Taking a look at each:
1. The direct method uses the official overall tax rate of the taxing jurisdiction in which the property is located and multiplies that rate by the assessment ratio of that subject property. As an example: Tax Rate x Assessment Ratio = Effective Tax Rate (ETR)
Continue to calculation of ETR…..
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Tax Rate (per county treasurer) x Assessment Ratio = Effective Tax Rate 0.12587 x 0.185 = 0.0233 or 2.33%
2. The market comparison method divides the most current year’s taxes for a comparable property by that year’s Full Cash Value for the property. Similar properties located in the same taxing jurisdiction as a subject property should yield similar ETRs.
For example, using information from treasurer (r.e.tax) and assessor’s (full cash value) :
Abernathy Business Park;
Property 2014 FCV As’ment 2014 Effective Tax Rate [1] APN FCV Ratio R E Tax ETR .
101050720 $642,500 0.21 $19,940 .03104
101050710 520,200 0.21 $16,142 .03103
101050750 651,000 0.21 $19,940 .03063
10105077E 902,000 0.21 $27,043 .02998
Mean 678,925 $20,766 .03067
21% in 2010; 20 % in 2011
Taxes ÷ Full Cash Value = Effective Tax Rate (ETR) $20,766 ÷ $678,925 = 0.03067 or 3.06% Overall
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Further, a third method is also logical:
3. Appraiser’s method, i.e. normally used in the fee appraisers’ practice the effective tax rate is simply the real estate tax amount divided by the sales price of a property (same concept as #2 above, but using sales price rather than FCV) Effective tax rate ETR = ($ SP) / ($ RE Tax). For example, Taxes ÷ Value evidenced by Sales Price = Effective Tax Rate (ETR) Example: $28,776 ÷ $870,000 = 0.0331 = 3.31 % Overall
But, for a broader base of support, it’s better to use a sample similar group of properties in the same tax and tax rate jurisdiction:
From market sales information, properties of same use as subject
Property Sales Price R E Tax ETR
1 $ 750,000 25,700 .03427
2 660,000 19,700 .03788
3 920,000 23,700 .02576
4 565,000 17,200 .03270
5 1,055,000 23,800 .02256
Mean ETR =.03063
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Other definitions and ETR calculations:
A commonly used definition of Effective Tax Rate is from Barron's Real Estate Dictionary:
Effective Tax Rate
The Ad Valorem tax payment compared with the Market Value of the property. Facilitates a comparison of taxes in different jurisdictions that apply different Assessment Ratios. Example: Community A applies a 50-mill rate to a 40% assessment ratio. The effective tax rate is 2% of the market value (50 mills = 5%; 5% x 40% = 2%).
Essentially the same is found in the Dictionary of Real Estate Terms
Next, ETR information from IAAO:
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From the International Association of Assessing Officers, IAAO, the definition of Effective Tax Rate is “…the rate expressing the ratio between the current tax bill and the property value.”
IAAO calculation example:
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From IAAO, continued….
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From IAAO, continued…. Reconstructing the Income Statement (as it pertains to the ETR)
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From IAAO, continued….
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From IAAO, continued….
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The bottom line:
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From The Appraisal of Real Estate, 14th ed. By The Appraisal Institute, page 108.
· S w a n g o · AZ DOR Continuing Education Program Aug., 2015